Edited version of private advice

Authorisation Number: 1051648898594

Date of advice: 3 April 2020

Ruling

Subject: Property development - the sale of real property

This ruling applies to the beneficiaries of the trust and to the trustee and to any future trustees, for as long as the ruling remains current.

Question 1

Are the proceeds or the net income from the sale of the Property ordinary income pursuant to section 6-5 of the Income Tax Assessment Act 1997?

Answer

No

Question 2

Are the proceeds from the sale of the Property on capital account and assessable exclusively under the capital gains tax provisions of Part 3-1 of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Development activities of the Group

The Principals conduct a property development through a Group of entities.

Prior to the Global Financial Crisis (GFC) in 20XX, the Principals had been actively involved in property development activities via their Group.

Development projects undertaken were for the Principals' or Group's own purposes rather than providing property development services for a third party. The Principals were the proponents of the project. Funding for the projects was via investors and Banks.

These projects were either mixed use projects residential and commercial or mainly commercial. The residential component of the mixed use projects were developed for sale. The retail/commercial component of mixed use projects were retained for investment.

The Principals accumulated an investment portfolio to generate ongoing income rather than rely on project profit.

Each of the projects were undertaken in a new single purpose entity.

Prior to the GFC several projects were undertaken.

Out of these projects, all of the retail/commercial properties were held solely for investment with the intention of earning rental income.

Residential property, with historically low yields or returns (approximately X% gross), is not as attractive as an ongoing investment or business model. Commercial/retail returns are historically higher at approximately X%.

The GFC had a significant negative impact on property values. Financiers of properties requested an updated valuation triggering a loan to value ratio default which the borrower was required to rectify by contributing additional equity which triggering asset sales in a declining market. All of the properties were sold as a result.

Since the GFC, the Principals have undertaken two projects, one being residential which was sold and the other being a commercial development.

A company was incorporated to act as trustee (Trustee) for a trust (Trust) to hold the development.

The Property

The Property was purchased for development

Construction funding was obtained.

A builder was engaged and construction was completed and the development was opened for business.

The development was constructed to a very high standard so that future property maintenance costs would be lower and the Property would continue to be attractive to tenants.

Following completion of the development, while the Trustee did not contemplate any possibility for a sale of the Property, they were approached by interested parties to acquire the Property given the strong tenancies and quality of the design and build.

Subsequent to the construction completion you refinanced the development for the maximum term the bank was willing to provide funding for.

The loan to fund the project was not 'negatively geared'.

After the five year term of the investment loan, the loan would have been refinanced with a new five year investment loan.

The Property was fully let.

Net rent from the Property (before interest and depreciation) provided 9% return on the total cost of the Property.

A combination of personal factors caused both Principals to re-evaluate their priorities in life and investigate the possibility of selling the Property rather than keep it as a long term investment as originally intended.

The Property was put on the market and sold.

A mortgage discharge fee (i.e. break-fee) for early termination of the five year fixed-term investment loan was paid.

Reasons for Decision

Question 1

Are the proceeds or the net income from the sale of the Property ordinary income pursuant to section 6-5 of the ITAA 1997?

Summary

The gross proceeds or net profit from the sale of the Property by the Trustee will not constitute ordinary income under section 6-5 of the ITAA 1997.

Detailed reasoning

There are three means by which proceeds from the sale of the Property owned by the Trust can be treated for taxation purposes:

1. As ordinary income under section 6-5 of the ITAA 1997, on revenue account, as income (gross proceeds) generated in the ordinary course of carrying on a business of property development, involving the purchase development and sale of land and buildings as trading stock.

2. As ordinary income under section 6-5 of the ITAA 1997, on revenue account, as a result of an isolated transaction, where net profits are included in assessable income.

3. As statutory income under the capital gains tax (CGT) legislation - section 102-5 of the ITAA 1997 - on the basis that a realisation of a capital asset has occurred.

The scope of the response to Question 1 will address the first two means only, with the third being discussed in the response to Question 2.

Section 6-5 of the ITAA 1997 provides that the assessable income of an Australian resident includes the ordinary income derived directly or indirectly from all sources, whether in or out of Australia.

'Ordinary income' is defined in section 6-5 of the ITAA 1997 to mean 'income according to ordinary concepts'. The legislation does not provide any specific guidance on what is meant by 'income according to ordinary concepts'. However, a substantial body of case law has evolved over time that identifies various factors that are taken into account in determining when an amount is 'income according to ordinary concepts'.

In general, a receipt will constitute income according to ordinary concepts if it is a receipt arising out of a taxpayer's employment or in the normal scope of a taxpayer's business. In limited circumstances, gains not within the ordinary scope of a taxpayer's business may form part of ordinary income.

Section 995-1 of the ITAA 1997 defines 'business as 'including any profession, trade, employment, vocation or calling, but does not include any occupation as an employee'.

Does the Property constitute trading stock?

Under section 70-10 of the ITAA 1997, 'trading stock' is defined as including 'anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business'.

In order to determine if the Property constitutes 'trading stock', it is necessary to firstly consider whether the Trust is carrying on a business of buying developing and selling real property.

Whether a business is being carried on is a question of fact and degree. The courts have developed a series of indicators that are applied to determine the matter on the particular facts.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? discusses the Commissioner's view on whether a taxpayer is carrying on a business. Ultimately, the question of whether the activities of a taxpayer amount to a business is decided on the facts of each case. The Commissioner considers that the following matters (listed at paragraph 13 of TR 97/11) are relevant in determining whether a taxpayer is conducting a business of acquiring and developing property for the purpose of making a profit on its subsequent sale:

1. whether the activity has a significant commercial purpose or character

2. whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

3. whether there is repetition and regularity of the activity

4. whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business

5. the volume of the operations and the amount of capital employed

6. whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit, and

7. the size, scale and permanency of the activity.

In determining whether a taxpayer is carrying on a business, no one indicator will be decisive. The indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the large or general impressions gained from considering all the indicators and whether these indicators provide the operations with a commercial profile.

Having regard to the factors in paragraph 13 of TR 97/11, the Commissioner is of the view that it is arguable that the Trust is in the business of property development for sale for the following reasons:

·         the Group, under the control of the Principals, have undertaken several land development projects over its history

·         to do this the principles have used a sophisticated structure to undertake the funding and creating entities specifically to undertake and hold those developments.

However, while the Group has purchased and developed property for sale in the past, the developments for sale were residential properties. In this case the development was in relation to a commercial property to hold as a long-term investment to derive a rental income stream.

The Trust was established to acquire this property only, and has no other activity or enterprise other than leasing of the commercial space at the Property. The Trust does not own any other property, and the Trustee and the Trust have not been involved in the development of other properties.

As the Trust is not carrying on a business of acquiring property for the purpose of profit-making by developing and selling properties, the Property would not constitute 'trading stock' under section 70-10 of the ITAA 1997.

Would the sale of the Property constitute an isolated commercial transaction?

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income provides the Commissioner's view on whether profits from isolated transactions are assessable as ordinary income under the former subsection 25(1) of the Income Tax Assessment Act 1936 (now section 6-5 of the ITAA 1997).

Paragraph 1 of TR 92/3 provides that the term 'isolated transaction' refers to those transactions:

1. outside the ordinary course of business, and

2. entered into by non-business taxpayers.

In particular, TR 92/3 sets out the Commissioner's views in relation to the application of the decision of the Full Court of the High Court of Australia in FC of T v The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693 (Myer Emporium). In the Myer Emporium case, the High Court said:

Although it is well settled that a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not follow that a profit or gain made in a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer's business is not income. Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business. Nor does the fact that a profit or gain is made as the result of an isolated venture or a 'one-off' transaction preclude it from being properly characterised as income...The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.

As held in Myer Emporium, whether a profit from an isolated transaction is income according to ordinary concepts depends on the circumstances of a case.

In circumstances where a taxpayer carrying on a business makes a profit from a transaction or operation, paragraph 15 of TR 92/3 states such a profit is income if the transaction or operation:

(a) is in the ordinary course of the taxpayer's business...provided that any gross receipt from the transaction or operation is not income; or

(b) is in the course of the taxpayer's business, although not within the ordinary course of that business, and the taxpayer entered the transaction or operation with the intention or purpose of making a profit; or

(c) is not in the course of the taxpayer's business, but

(i) the intention or purpose of the taxpayer in entering into the transaction or operation was to make a profit or gain; and

(ii) the transaction or operation was entered into, and the profit was made, in carrying out a business operation or commercial transaction.

However, paragraph 15 of TR 92/3 is applicable only if the Trust is carrying on a business.

As previous discussed, the Commissioner concluded that the Trust is not carrying on a business of property development involving the purchase, development and subsequent sale of real property. For the same reasons, the Commissioner also considers that the leasing enterprise undertaken by the Trust does not constitute the carrying on of a business. The basis for this view is that the Trust uses the Property merely for passive rental income purposes. The Trust was established to acquire this property only, and has no other activity other than leasing of the commercial space at the Property, and the Trust does not own any other property.

Therefore, as the leasing enterprise carried on by the Trust is merely of a passive nature and does not constitute the carrying on of a business, paragraph 16 of TR 92/3 would be relevant in the event the Trust makes a net profit from the sale of the Property. Paragraph 16 of TR 92/3 states the following:

If a taxpayer not carrying on a business makes a profit, that profit is income if:

(a) the intention or purpose of the taxpayer in entering into the profit-making transaction or operation was to make a profit or gain; and

(b) the transaction or operation was entered into, and the profit was made, in carrying out a business operation or commercial transaction.

Each of the two elements or conditions in paragraph 16 of TR 92/3 is discussed below in considering whether or not a profit made by the Trust from the sale of the Property would be income.

Intention or purpose of the Trust in entering a profit-making transaction or operation

According to paragraphs 7 and 8 of TR 92/3, the relevant intention or purpose of the taxpayer (of making a profit or gain) is not the subjective intention or purpose of the taxpayer, but rather the taxpayer's intention or purpose that can be discerned from an objective consideration of the facts and circumstances of the case.

It is also not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. Paragraph 40 of TR 92/3 provides that it is sufficient if profit-making is a significant purpose. However, the profit-making purpose must be more than a mere possibility. In Westfield v FCT 91 ATC 4234, Hill J said:

While a profit-making scheme may lack specificity of detail, the mode of achieving that profit must be one contemplated by the taxpayer as at least one of the alternatives by which the profit could be realised ... But, even if that goes too far, it is difficult to conceive of a case where a taxpayer would be said to have made a profit from the carrying on, or carrying out, of a profit-making scheme, where, in the case of the scheme involving the acquisition and resale of land, there was, at the time of acquisition, no purpose of resale of land, but only the possibility (present, one may observe, in the case of every acquisition of land) that the land may be resold.

The Commissioner's view, as set out at paragraph 41 of TR 92/3, states that if a transaction or operation involves the sale of property it is usually necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property. However, this is not always the case, as there may be special circumstances where the requisite profit-making purpose arises sometime after acquisition of a property.

An example is provided in paragraph 42 of TR 92/3 where a taxpayer acquires an asset with the intention of using it for personal enjoyment but later decides to venture or commit the asset either as the capital of a business or into a profit-making undertaking or scheme with the characteristics of a business operation or commercial transaction. In such circumstances, the activity of the taxpayer would constitute the carrying on of a business or a business operation or commercial transaction carrying out a profit-making scheme, as the case may be. The profit from the activity would be income despite the taxpayer not having the purpose of profit-making at the time of acquiring the asset.

Based on an objective consideration of the facts provided, the Commissioner is of the view that - while the sale of the Property may constitute a profit-making undertaking - the Trustee did not have the requisite profit-making purpose when the Property was acquired:

1. When the Trustee purchased the Property, the Trustee's intention was to acquire and hold the Property as a long-term investment to derive rental income. The Trustee has continuously held the Property for this purpose since its acquisition.

3. The Trust has no other activity or enterprise other than leasing of the commercial space at the Property, and the Trust does not own any other property.

4. When the Trustee purchased the Property, a sale for profit was no more than a mere possibility.

5. When the Trustee purchased the Property, it could not have known (or predicted) that the personal circumstances of the Principles would change.

6. Previous commercial property developments of the Group have been held for longer periods for rental income.

Therefore, the first element/condition (profit-making purpose) of paragraph 16 of TR 92/3 is not satisfied.

Carrying out of a business operation or commercial transaction

For a transaction to be characterised as a business operation or a commercial transaction, paragraph 47 of TR 9/3 states that it is sufficient if the transaction is business or commercial in character. However, whether a particular transaction has a business or commercial character depends very much on the circumstances of the case.

Paragraph 49 of TR 92/3 provides that a transaction or operation has the character of a business operation or commercial transaction if the transaction or operation would constitute the carrying on of a business except that it does not occur as part of repetitious or recurring transactions or operations. That paragraph highlights the following factors which may be relevant in determining whether an isolated transaction amounts to a business operation or commercial transaction:

(a) the nature of the entity undertaking the operation or transaction (Ruhamah Property Co. Ltd. v F C of T(1928) 41 CLR 148 at 154; Hobart Bridge Co. Ltd. v FC of T (1951) 82 CLR 372 at 383; FC of T v Radnor Pty Ltd 91 ATC 4689; 22 ATR 344). For example, if the taxpayer is a corporation with substantial assets rather than an individual, that may be an indication that the operation or transaction was commercial in nature. However, if the taxpayer acts in the capacity of trustee of a family trust, the inference that the transaction was commercial or business in nature may not be drawn so readily;

(b) the nature and scale of other activities undertaken by the taxpayer (Western Gold Mines N.L. v C. of T. (W.A.) (1938) 59 CLR 729 at 740);

(c) the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;

(d) the nature, scale and complexity of the operation or transaction;

(e) the manner in which the operation or transaction was entered into or carried out. This factor would include whether professional agents and advisers were used and whether the operation or transaction took place in a public market;

(f) the nature of any connection between the relevant taxpayer and any other party to the operation or transaction. For example, the relationship between the parties may suggest that the operation or transaction was essentially a family dealing and not business or commercial in nature;

(g) if the transaction involves the acquisition and disposal of property, the nature of that property (Edwards v. Bairstow; Hobart Bridge 82 CLR at 383). For example, if the property has no use other than as the subject of trade, the conclusion that the property was acquired for the purpose of trade and, therefore, that the transaction was commercial in nature, would be readily drawn; and

(h) the timing of the transaction or the various steps in the transaction (Ruhamah Property 41 CLR at 154). For example, if the relevant transaction consists of the acquisition and disposal of property, the holding of the property for many years may indicate that the transaction was not business or commercial in nature.

Of the two elements/conditions of paragraph 16 of TR 92/3, both must be satisfied in order for a profit from an isolated transaction (where a business is not being carried on) to be classified as income. As concluded earlier, the first element/condition (profit-making purpose) of paragraph 16 of TR 92/3 is not satisfied. Therefore, it is not necessary to discuss further the second element/ condition (business operation or commercial transaction) of paragraph 16 of TR 92/3.

As both of the elements/conditions of paragraph 16 of TR 92/3 would not be satisfied in respect of the scheme, any net profit the Trustee receives from the sale of the Property would not constitute income under section 6-5 of the ITAA 1997.

Conclusion

The Trust is not carrying on a business of property development involving the purchase development and sale of land and buildings as trading stock. As such, (gross) proceeds from the sale of the Property owned by the Trust would not be treated as ordinary income under section 6-5 of the ITAA 1997 on the basis of the Trustee carrying on a business of property development.

The leasing enterprise undertaken by the Trust also does not constitute the carrying on of a business.

A net profit from an isolated transaction, being the sale of the Property, also would not constitute ordinary income under section 6-5 of the ITAA 1997, as both of the elements/conditions of paragraph 16 of TR 92/3 would not be satisfied in respect of the sale transaction. In particular, the Trustee did not have the requisite profit-making purpose when the Property was acquired, nor did a profit-making purpose arise at any time after the Trust's acquisition of the Property.

Therefore, the gross proceeds or net profit from the sale of the Property by the Trustee will not constitute ordinary income under section 6-5 of the ITAA 1997.

Question 2

Are the proceeds from the sale of the Property on capital account and assessable exclusively under the capital gains tax provisions of Part 3-1 of the ITAA 1997?

Summary

The gain on the sale of the Property by the Trustee would be assessable as statutory income as a disposal of a CGT asset.

Detailed reasoning

Under section 6-10 of the ITAA 1997, assessable income also includes amounts that are not ordinary income but are included as assessable income by provisions of the tax law. These amounts are called 'statutory income'. Capital gains are an example of statutory income.

Section 102-5 of the ITAA 1997 provides that a taxpayer's assessable income includes their net capital gain (if any) for the income year. As a general rule, a taxpayer is required to include in their assessable income any capital gain they make from a CGT event that happens to a CGT asset the taxpayer acquired on or after 20 September 1985. Pursuant to section 108-5 of the ITAA 1997, a CGT asset is any kind of property, or a legal or equitable right that is not property. Accordingly, land and buildings are CGT assets.

Proceeds from the sale of property more often represent the mere realisation of capital assets, which will fall for consideration under the CGT provisions in Part 3-1 and Part 3-3 of the ITAA 1997.

In the course of its decision in Myer Emporium, the Full High Court said that profits made on a realisation or change of investments may constitute income if the investments were initially acquired as part of a business with the intention or purpose that they be realised subsequently in order to capture the profit arising from the expected increase in value. In a joint judgment, their Honours stated:

It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit-making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realization. But it is quite another thing if the decision to sell is taken by way of implementation of an intention or purpose, existing at the time of acquisition, of profit-making by sale, at least in the context of carrying on a business or carrying out a business operation or commercial transaction.

Paragraph 36 of TR 92/3 states:

The courts have often said that a profit on the mere realisation of an investment is not income, even if the taxpayer goes about the realisation in an enterprising way. The expression 'mere realisation' is used to contradistinguish a business operation or a commercial transaction carrying out a profit-making scheme. If a transaction satisfies the elements set out in paragraph 35¹, it is generally not a mere realisation of an investment.

As per the Commissioner's response to Question 1, the Trustee did not have a profit-making intent at the time of purchasing the Property, as the Trustee's intention was to hold the Property as an investment that would generate passive rental income/capital returns on a long-term basis. The Trustee was not carrying on a business of purchasing, developing and selling real property. The requisite profit-making purpose also did not arise at any time after the Trust's acquisition of the Property, as determined in the response to Question 1.

Without a profit-making intent, the activities of the Trust would not ordinarily be regarded as revenue-based income.

Despite the potentially sizeable profit from the sale of the Property, the mere magnitude of the realisation does not convert the activities of the Trustee into a business (as held in Statham).

Therefore, in applying the principle held in Myer Emporium as stated above, as the Property is a capital asset and not a revenue asset, and in the absence of a profit-making intent by the Trustee, it is the Commissioner's view that the sale of the Property would more accurately represent the mere realisation of a capital asset.

As a mere realisation of a capital asset, the proceeds from the sale of the Property would not be assessable as ordinary income under section 6-5 of the ITAA 1997. The proceeds from the sale of the Property would be subject to the CGT provisions provided in Part 3-1 and Part 3-3 of the ITAA 1997.

CGT event A1 in section 104-10 of the ITAA 1997, relating to the disposal of a CGT asset, will happen when the Trustee disposed of the Property. There is a capital gain if the capital proceeds from the disposal are more than the cost base. A capital loss occurs if the capital proceeds are less than the reduced cost.